This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

January 4, 2013

What the Movement of the VIX Tells Us About Investing

With mutual fund capital gains and now the fiscal cliff behind us, is it safe to go back into the investing water?

When the stock market started its descent in October 2007, volatility, as measured by the VIX, was around 20. It started to rise from there, reaching a peak of 80.1 on October 27, 2008. A reading of 80 on the VIX is about as extreme as it gets! When the market bottomed four and a half months later on March 9, 2009 and began its ascent, the VIX was still well above normal at 49.7. As of 9:30 EST this morning, the VIX was back down at 14.68; on December 28, the VIX stood at 22.7.

The VIX has a strong negative correlation with stocks. In essence, when volatility is rising, stocks trend lower and vice versa. This relationship is equally true with another fear index, the St. Louis Fed Stress Index.

The moral to the story? When fear sets in, it does so rather quickly and that's why stocks fall faster than they rise, generally speaking. Then, when stocks bottom and begin to rise, it takes a while for fear to normalize. If 20 is considered normal on the VIX, after the market bottomed in March 2009, the VIX didn't fall below 20 until December 22, some nine months later.

Investors may indeed have a short memory, but after a season like we had in 2008, I believe the psychological effects are still lingering. Indications are that a great deal of cash is still on the sidelines and stock mutual funds continue to experience outflows. After the Great Depression, it took just over 25 years for the market to overtake its 1929 peak. That was much more extreme than the Great Recession, but it does suggest that patience is truly a virtue when investing in stocks. Although it may sound like it, I'm not really a bear. However, I have developed a healthy respect for the stock market. Hence, when volatility strikes, a smaller allocation to this vital asset class will feel much better.

The conclusion? No one really knows which direction stocks will take from here.